When the black swan visits

Tue 11 Feb 2020

Since 2018, a key concern of financial markets has been the increasing trade tensions between the United States and China, more commonly referred to as the ‘trade war’. With delays and failed negotiations lasting over a year, markets finally breathed a sigh of relief on the 15^th of January, as the US President Donald Trump hailed a trade truce with Beijing in the form of a ‘phase one’ trade agreement. The two year-long trade disruption has already taken a toll on the global economy, as China, the world’s marginal consumer for capital goods has slowed down its purchases from other nations. The question in investors’ minds is: can the truce hold long enough to help the global economy pick up the pace?

The centerpiece of the trade agreement is a commitment by China to import an additional $200 billion worth of American goods and services over the next two years. Chapter 6 of the agreement contains details of the commitments for China to make additional purchases of $77 billion in 2020 and $123 billion in 2021 as per the 2017 pre-trade war baseline level.  A good gauge to assess if this is an achievable target is to analyse how much China already imports from the US. In 2017, China imported almost $134 billion worth of goods and services from the US. However, this fell to around $120 billion in 2018 as buyers shunned American soy and corn as the trade war was declared.

If fulfilled, China’s purchases will increase to $210 billion and $257 billion in 2020 and 2021 respectively, amounting to a 92% increase in imports into China and an 18% annualised US export growth over 2017-2021. For perspective, US export growth to China averaged 20% per annum when China’s economy was booming in the early 2000s. Bearing in mind the fact that China’s economy is currently growing at around 6% (which is nearly half of what it was in the early 2000s), sustaining 18% annual export growth presents a significant challenge, particularly as Chinese demand for soy beans has been hit by the swine flu epidemic.

Whilst it will be difficult to evaluate whether China has met its 2020 target until March 2021, which is when the official US trade statistics for 2020 will be available, the clock is ticking. The agreement consists of a dispute resolution chapter which has two possible solutions. The first is a process of bilateral consultations between the two countries, without any third party arbitrators like the World Trade Organisation. Post these consultations, if it is established that China has not purchased the required amounts as stated in Chapter 6 of the agreement, the second solution is a proportional retaliation from the US.

So, is it realistically possible for China to effectively double its purchases from the US over the next two years? This question matters, because with unrealistic export targets, the deal may be doomed from the start. Whilst China has signed the agreement and accepted the dispute resolution process, there is very little that prevents China from pulling out of the deal, as there are no termination clauses in the agreement.

Since 2018, the Chinese economy has faced a slowdown in growth and rise in unemployment. Whilst tariffs imposed in July 2019 stay in place despite the agreement, China now has a bigger problem on its hands – the coronavirus; arguably a black swan in nature given few (if any!)  market strategists had this written down as a major risk in their 2020 outlooks. The coronavirus originated from the Chinese city of Wuhan, a major business hub which is currently in lockdown. The spread of the virus has caused major disruptions to air travel, with major airlines refusing to operate flights to the region. Chinese manufacturing hubs in Jiangsu, Changning and Guangdong have been shut down beyond the week-long lunar New Year holiday. Shutting down crucial parts of the world’s largest economy has subsequently had significant knock-on effects for the global economy.

The coronavirus outbreak arrived at a time when it appeared that the global market outlook was improving. With a lower for longer global interest rate environment and hopes for improvement in global growth after the signing of the “phase one” trade agreement, equity valuations were looking impressive. Prices took their first hit after last month’s assassination of Iran’s top general, Qasem Soleimani, by the US. The coronavirus hit markets once again, with Chinese markets experiencing their weakest opening in 15 years, down more than 7%, coupled with significant shocks to the commodity markets, with the oil price down nearly 11%.

The spread of the virus has led China to facilitate a new wave of ‘forced de-globalisation’. Barriers to trade are currently being implemented not to scale back trade and migration, rather as a manner of minimising the spread of infection. Though, the economic effects of these remain as expected. With lower business confidence and reduced international trade, policymakers can seek to provide stimulus to support global growth, but remain somewhat powerless in jumpstarting business’ economic activity. This leaves the global economy relying on nature’s will – a circumstance not favoured by financial markets.

The ‘phase one’ deal targets were adventurous to begin with. Coronavirus will make them even harder, but could be used as a mitigating factor if the political will in the US for further trade wars wane. And of course, by the time March 2021 comes around, there may be a different administration in place in the White House, but certainly not in Beijing.